It's important for investors to understand the key differences between individual stocks and exchange-traded funds (ETFs). Each has its advantages and disadvantages. This knowledge can translate into making informed investment decisions. Let's focus on the key points.
Diversification- Diversification is an attractive feature of ETFs. Instead of taking concentrated risks by purchasing individual stocks, investors can own an index of stocks with ETFs. Owning individual stocks has special risks and often requires diligent attention. In addition to reducing market volatility, many investors have cut their commitment to time consuming and expensive stock research. By over and underweighting ETF industry sectors, for example, investors can obtain an optimal allocation that suits their financial goals.
Leverage - Like individual stocks, ETFs can be leveraged with margin. Margin is borrowing money from a broker to buy securities and involves considerable risk. Minimum maintenance requirements are enforced by the by individual lenders. While margin investing can be profitable for investors correct about the direction of their holdings, the interest charges or borrowing costs can deteriorate returns.
Options - There are a multiplicity of option strategies with both stocks and ETFs. Purchasing call or put options is an aggressive technique. An options investor can control a large amount of ETF shares by paying a premium. The premium price is a fraction of what it would cost to purchase the shares in the open market. This provides an options investor with a great deal of leverage and a high risk/reward opportunity. A more defensive approach uses put options in conjunction with portfolio holdings. Buying protective puts on ETF or stock positions would insure a portfolio against declining prices. There are many other tactical possibilities with options.
Shorting - ETFs, like individual stocks, can be shorted. Shorting involves selling borrowed shares an investor does not own in expectation the price of an ETF will decline in value. If the ETF does decrease in value, it can be bought by the short seller at a lower price, which results in a profit. In 2009, the ASIC determined that all shorting must be ‘covered’, this means that you must borrow the stock from a margin lender before implementing this strategy. Shorting is an advanced technique and involves substantial risk
